P.S. By the way, one thing I noticed in the above chart is that Singapore has surpassed Hong Kong in the past couple of decades. This could just be a statistical blip, though I wonder if this is a result of the transfer of Hong Kong from British control to Chinese control. Yes, China has wisely chosen not to interfere with Hong Kong’s domestic policy, but perhaps investors and entrepreneurs don’t fully trust that this economic autonomy will continue.

Today, let’s look at convergence between Western Europe and Eastern Europe.

Here are some excerpts from a new study published by the European Central Bank.

This paper analyses real income convergence in central, eastern and south-eastern Europe (CESEE) to the most advanced EU economies between 2000 and 2016. …The paper establishes stylised facts of convergence, analyses the drivers of economic growth and identifies factors that might explain the differences between fast- and slow-converging economies in the region. The results show that the most successful CESEE economies in terms of the pace of convergence share common characteristics such as, inter alia, a strong improvement in institutional quality and human capital, more outward-oriented economic policies, favourable demographic developments and the quick reallocation of labour from agriculture into other sectors. Looking ahead, accelerating and sustaining convergence in the region will require further efforts to enhance institutional quality and innovation, reinvigorate investment, and address the adverse impact of population ageing.

The study is filled with fascinating data (at least if you’re a policy wonk).

This chart, for example, shows how many nations are converging (the dots above the diagonal line) and how many nations are falling behind (the dots below the diagonal line).

The yellow dots are Eastern European nations, so it’s good news that all of them are experiencing some degree of convergence.

But the above graphic doesn’t provide any details.

So let’s look at another chart from the study. The blue bar shows per-capita GDP in selected Eastern European nations as a share of the EU average. The yellow dot shows where the countries were in 2008 and the orange dot shows where they were in 2000.

The good news, at least relatively speaking, is that all nations are catching up to Western Europe.

But the report notes that some are catching up faster than others.

The developments were…heterogeneous within CESEE countries that are EU Member States. Some of them (the Baltic States, Bulgaria, Poland, Romania and Slovakia) experienced particularly fast convergence in the period analysed. At the same time, other CESEE EU Member States found it hard to converge… In fact, GDP per capita in Croatia and Slovenia diverged from the EU average after 2008… Given these heterogeneous developments, it appears that while in some CESEE countries the middle-income trap hypothesis could be dismissed (at least given their experience so far), in others the signs of a slowdown in convergence after reaching a certain level of economic development are visible.

My one gripe with the ECB study is that there’s a missing piece of analysis.

The report does a great job of documenting relative levels of prosperity over time. And it also has a thorough discussion of the characteristics that are found in fast-converging countries.

But there’s not nearly enough attention paid to the policies that promote and enable convergence. Why, for instance, has there been so much convergence in Estonia and so little convergence in Slovenia?

Like this:

A key insight of international economics is that there should be “convergence” between rich countries and poor countries, which is just another way of saying that low-income nations – all other things being equal – should grow faster than high-income nations and eventually attain the same level of prosperity.

The theory is sound, but it’s very important to focus on the caveat about “all other things being equal.” As I explain in this interview from my last trip to Australia, countries with bad policy will grow slower than nations that follow the right policies.

I also share the data showing that Europe was catching up to the United States after World War II, just as predicted by the theory, but then convergence ground to a halt once those nations imposed some bad policy – such as costly welfare states.

In other words, convergence is a choice, not destiny.

Countries with small government and laissez-faire markets are the ones that grow and converge. The nations with statist policy languish and suffer. Or even de-converge (with Argentina and Venezuela being depressing examples).

Let’s see what academics have to say about this issue.

We’ll start by looking at some research at VoxEU by Professor Linda Yueh. She wants to understand the characteristics that determine national prosperity.

It’s a long-standing economic question as to why more countries are not prosperous. …The World Bank estimates that of the 101 middle-income economies in 1960, just a dozen or so had become prosperous by 2008… But, hundreds of millions of people have joined the middle classes. …How has this been achieved? Possessing good institutions is what economists have come to focus on and the spread of such institutions seems to have been key…the father of New Institutional Economics…Douglass North…stressed that there was no reason why countries could not learn from more successful economies to better their own institutions. That finally happened in the 1990s.

I’m a fan of Douglass North since he – along with many other winners of the Nobel Prize – has endorsed tax competition.

In his case, the goal was for nations to face pressure to adopt good institutions.

And Professor Yueh explains that this means rule of law and free markets.

China, India, and Eastern Europe changed course. China and India re-oriented their economies outward to integrate with the world economy, while Eastern Europe shed the old communist institutions and adopted market economies. In other words, having tried central planning (in China and the former Soviet Union) and import substitution industrialisation (in India), these economies abandoned their old approaches and adopted as well as adapted the economic policies of more successful economies. For instance, China, which has accounted for the bulk of poverty reduction since 1990, undertook an ‘open door’ policy that sought to integrate into global production chains which increased competition into its economy that had been dominated by state-owned enterprises. India likewise abandoned its previous protectionist policies…in Central and Eastern Europe. Communism gave way to capitalism, with these nations adopting entirely new institutions that re-geared their economies toward the market.

All of this is good news, but not great news. Simply stated, partial liberalization can lift people out of poverty.

But it takes comprehensive liberalization for a nation to become genuinely rich.

As many of these economies, especially China, have become middle-income countries, their economic growth is slowing down. And they may slow down so far that they never become rich. But, their collective growth has lifted a billion people of out of extreme poverty.

Let’s now see what other scholars say about convergence.

Some new research from the St. Louis Federal Reserve examines this topic. Here’s the mystery they want to address.

Over the past half-century, world income disparities have widened. The gap in real gross domestic product (GDP) per capita relative to the United States between advanced and poor countries has increased. For example, the ratio of average real GDP per capita among the top 10 percent of countries to the bottom 10 percent has increased from less than 20 in 1960 to more than 40 in 1990, and to more than 50 since the turn of the new millennium… The main point to be addressed in this article is why the income disparities between fast-growing economies and development laggards have widened.

In other words, they want to understand why some nations converge and some don’t.

We select a set of 10 fast-growing economies. This set includes Asian countries and African economies that are perceived as better performing. In contrast, we select a set of 10 development laggards. Beyond the typical candidates of countries mired in the poverty trap, this set includes countries with similar or even better initial states than some of the fast-growing countries, but with divergent paths of development leading to worse macroeconomic outcomes. That is, among development laggards, we choose two subgroups, one consisting of trapped economies and another of lag-behind countries. …Using cross-country analysis, we find that a key factor for fast-growing countries to grow faster than the United States and for trapped economies to grow slower than the United States is the relative TFP… Overall, we find that institutional barriers have played the most important role, accounting for more than half the economic growth in fast-growing and trapped economies and for more than 100 percent of the economic growth in the lag-behind countries.

Here are their case studies, showing income relative to the United States (a 1.0 means the same degree of prosperity as America).

As you can see, some nations catch up and some fall further behind, while others have periods of convergence and de-convergence.

And what causes these changes?

The degree to which nations have good policy.

…we identify that unnecessary protectionism, government misallocation, corruption, and financial instability have been key institutional barriers causing countries to either fall into the poverty trap or lag behind without a sustainable growth engine. Such barriers have created frictions or distortions to capital markets, trade, and industrialization, subsequently preventing these countries from advancing. …By reviewing the previous country-specific details, one can see that the 10 fast-growing countries have all adopted an open policy… Their governments have undertaken serious reforms, particularly in both labor and financial markets. …Thus, the establishment of correct institutions and individual incentives for better access to capital markets, international trade, and industrialization can be viewed as crucial for a country to advance with sustained economic growth

Here’s a table from the report showing the policies that help and the policies that hurt. Needless to say, it would be good if the White House understood that protectionism is one of the factors that undermine growth.

Interestingly, the study from the St. Louis Federal Reserve includes some country-specific analysis.

Here’s what it said about India, which suffered during an era of statism but has enjoyed decent growth more recently thanks to partial liberalization.

During 1950-90, India’s per capita income grew at an average annual rate of only about 2 percent, a result due to the Indian government’s implementation of restrictive trade, financial, and industrial policies. The Indian state took control of major heavy industries, by including additional licensing requirements, capacity restrictions, and limits on the regulatory framework. …In the late 1970s, the Indian government opened the economy by liberalizing both international trade and the capital market, leading to rapid growth in the early 1990s. As argued by Rodrik and Subramanian (2005), the trigger for India’s economic growth was an attitudinal shift on the part of the national government in 1980 in favor of private businesses. …The final trigger of the major economic reform of Manmohan Singh in the 1990s was due to the well-known 1991 balance-of-payment crisis….This reform ended the protectionist policies followed by previous Indian governments and started the liberalization of the economy toward a free-market system. This event led to an average annual growth rate that exceeded 6 percent in per capita terms during 1990-2005.

We also have some discussion regarding Argentina, which is mostly a sad story of ever-expanding government.

Argentina is the third-largest economy in Latin America and was one of the richest countries in the world in the early twentieth century. However, after the Great Depression, import substitution generated a cost-push effect of high wages on inflation. During 1975-90, growing government spending, large wage increases, and inefficient production created chronic inflation that increased until the 1980s, and real per capita income fell by more than 20 percent. …In 1991, the government attempted to control inflation by pegging the peso to the U.S. dollar. In addition, it began to privatize state-run enterprises on a broader basis and stop the run of government debt. Unfortunately, lacking a full commitment, the economy continued to crumble slowly and eventually collapsed in 2001 when the Argentine government defaulted on its debt. Its GDP declined by nearly 20 percent in four years, unemployment reached 25 percent, and the peso depreciated by 70 percent after being devalued and floated.

But if we go to the other side of the Andes Mountains, we find some good news in Chile.

From the Second World War to 1970, real GDP per capita of Chile increased at an average annual rate of 1.6 percent, and its economic performance was behind those of Latin America’s large and medium-sized countries. Chile pursued an import-substitution strategy, which resulted in an acute overvaluation of its currency that intensified inflation. …Although most Latin American countries have practiced strong government intervention in the markets since the mid-1970s, Chile pursued free market reform. …The outcomes are as follows: Exports grew rapidly, per capita income took off, inflation declined to single digits, wages increased substantially, and the incidence of poverty plummeted (compare with Edwards and Edwards, 1991). Since the democratic administration of Patricio Aylwin in 1990, the economic reform has been accelerated and Chile has become one of the healthiest economies in Latin America.

Not only has Chile become the richest nation in Latin America, it also has enjoyed significant convergence with the United States. About 40 years ago, according to the Maddison database, per-capita GDP in Chile was only about 20 percent of U.S. levels. Now it is 40 percent.

I’ll close with a chart, based on the Maddison numbers, showing how Hong Kong, Singapore, and Switzerland have converged with the United States. These are the only nations that have ranked in the top-10 for economic freedom ever since the rankings began. As you can see, their reward is prosperity.

I’m a fan of the Baltic nations in part because they were among the first to adopt flat tax systems after the collapse of the Soviet empire. But tax reform was just the beginning. Estonia, Latvia, and Lithuania have liberalized across the board as part of their efforts to become prosperous.

The Baltic States have been able to maintain an impressive rate of convergence towards the average EU per capita income over the past 20 years. …these three countries have each pursued a strongly free-market and pro-business economic agenda… The three countries are different in many ways, but share a number of key features: very high levels of trade and financial openness and very high labour mobility; high economic flexibility with wage bargaining mainly at firm level; relatively good institutional framework conditions; and low levels of public debt.

And this has translated into strong growth, which has resulted in higher incomes.

The Baltic States are among the few euro area countries (along with Slovakia) in which real GDP per capita in purchasing power standard (PPS) terms has shown substantial convergence towards the EU average over the last 20 years. While in 1995 their average per capita income (in PPS) stood at only around 28% of the EU15 average, in 2015 it reached 66.5% (see Chart A).

Here’s the chart showing how quickly the Baltic countries are catching up to Western Europe.

The ECB report also measured how fast the Baltic nations have grown compared to theory.

The long-term convergence performance of the Baltic States has exceeded what would have been expected based on their initial income level.

And here’s the chart showing how they have over-performed.

The ECB study says that the Baltic countries have been especially good about replacing cronyism with the rule of law.

One of the possible reasons for the fairly strong convergence performance of the Baltic States is the strong improvement in institutional quality in these countries… The Worldwide Governance Indicators of the World Bank, which is a composite indicator of institutional quality, suggests that institutional quality has improved markedly in the Baltic States – especially in Estonia – over the recent decades.

I agree. Indeed, I’ve written that Estonia is a good role model, having reduced corruption by limiting the power of politicians and bureaucrats.

While the crisis hit the Baltic States hard, the adjustment of imbalances was very fast. The rapid adjustment in fiscal balances and private sector balance sheets implied that the Baltic States could avoid the accumulation of a large debt overhang. In addition, the fast reduction in unemployment helped to decrease the risk of hysteresis, thus avoiding lasting consequences for potential growth. …The external adjustment of the Baltic States was facilitated by painful but effective internal devaluation. …This relatively fast adjustment in the Baltic States was facilitated in part by a strong initial rebound in employment growth, supported by an adjustment in labour costs.

Though the report does warn that there are not guarantees that the Baltic countries will fully converge with Western Europe.

International experience suggests that countries that reach a middle income level, like the Baltic States, tend to find it difficult to converge further and achieve a high income level. A World Bank study suggests that out of 101 middle-income economies in 1960, only 13 had become high-income economies by 2008.

Unfortunately, this is one area where the Baltic nations are weak. Yes, the burden of government spending may be modest compared to other EU countries, but the public sector nonetheless consumes more than 35 percent of GDP. And even though these nations have flat taxes, they also have stifling payroll taxes and government-fueling value-added taxes.

Another problem (not just in the Baltic region, but all through Eastern Europe) is that the demographic outlook is unfriendly, which means that the welfare state automatically will become a bigger burden over time.

If the Baltic countries want genuine convergence (or if they want to surpass Western Europe), that will require additional reform, particularly efforts to reduce the burden of government spending to the levels found in Hong Kong and Singapore.

Unfortunately, it’s more likely that policy will move in the other direction. There are constant efforts to repeal the flat tax systems in the Baltic countries. And efforts by the European Commission to harmonize business taxation ultimately may undermine the pro-growth approach to business taxation in the region as well.

P.S. For those who want an in-depth look at a Baltic nation, I recommend this video about Estonia. And if you want some amusement, check out how Paul Krugman wanted people to believe that Estonia’s 2008 recession was caused by 2009 spending cuts.